Guidebook for Evaluating Fuel Purchasing Strategies for Public Transit Agencies (2012)

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T R A N S I T C O O P E R A T I V E R E S E A R C H P R O G R A M TCRP REPORT 156 TRANSPORTAT ION RESEARCH BOARD WASHINGTON, D.C. 2012 www.TRB.org Research sponsored by the Federal Transit Administration in cooperation with the Transit Development Corporation Subscriber Categories Public Transportation • Administration and Management • Finance Guidebook for Evaluating Fuel Purchasing Strategies for Public Transit Agencies David Friedman and Kevin DeCorla-Souza Science ApplicAtionS internAtionAl corporAtion McLean, VA

TCRP REPORT 156 Project G-12 ISSN 1073-4872 ISBN 978-0-309-25834-0 Library of Congress Control Number 2012941463 © 2012 National Academy of Sciences. All rights reserved. COPYRIGHT INFORMATION Authors herein are responsible for the authenticity of their materials and for obtaining written permissions from publishers or persons who own the copyright to any previously published or copyrighted material used herein. Cooperative Research Programs (CRP) grants permission to reproduce material in this publication for classroom and not-for-profit purposes. Permission is given with the understanding that none of the material will be used to imply TRB, AASHTO, FAA, FHWA, FMCSA, FTA, or Transit Development Corporation endorsement of a particular product, method, or practice. It is expected that those reproducing the material in this document for educational and not-for-profit uses will give appropriate acknowledgment of the source of any reprinted or reproduced material. For other uses of the material, request permission from CRP. NOTICE The project that is the subject of this report was a part of the Transit Cooperative Research Program, conducted by the Transportation Research Board with the approval of the Governing Board of the National Research Council. The members of the technical panel selected to monitor this project and to review this report were chosen for their special competencies and with regard for appropriate balance. The report was reviewed by the technical panel and accepted for publication according to procedures established and overseen by the Transportation Research Board and approved by the Governing Board of the National Research Council. The opinions and conclusions expressed or implied in this report are those of the researchers who performed the research and are not necessarily those of the Transportation Research Board, the National Research Council, or the program sponsors. The Transportation Research Board of the National Academies, the National Research Council, and the sponsors of the Transit Cooperative Research Program do not endorse products or manufacturers. Trade or manufacturers’ names appear herein solely because they are considered essential to the object of the report. TRANSIT COOPERATIVE RESEARCH PROGRAM The nation’s growth and the need to meet mobility, environmental, and energy objectives place demands on public transit systems. Current systems, some of which are old and in need of upgrading, must expand service area, increase service frequency, and improve efficiency to serve these demands. Research is necessary to solve operating problems, to adapt appropriate new technologies from other industries, and to intro- duce innovations into the transit industry. The Transit Cooperative Research Program (TCRP) serves as one of the principal means by which the transit industry can develop innovative near-term solutions to meet demands placed on it. The need for TCRP was originally identified in TRB Special Report 213—Research for Public Transit: New Directions, published in 1987 and based on a study sponsored by the Urban Mass Transportation Administration—now the Federal Transit Admin istration (FTA). A report by the American Public Transportation Association (APTA), Transportation 2000, also recognized the need for local, problem- solving research. TCRP, modeled after the longstanding and success- ful National Cooperative Highway Research Program, undertakes research and other technical activities in response to the needs of tran- sit service providers. The scope of TCRP includes a variety of transit research fields including planning, service configuration, equipment, facilities, operations, human resources, maintenance, policy, and administrative practices. TCRP was established under FTA sponsorship in July 1992. Pro- posed by the U.S. Department of Transportation, TCRP was autho- rized as part of the Intermodal Surface Transportation Efficiency Act of 1991 (ISTEA). On May 13, 1992, a memorandum agreement out- lining TCRP operating procedures was executed by the three cooper- ating organizations: FTA, the National Academies, acting through the Transportation Research Board (TRB); and the Transit Development Corporation, Inc. (TDC), a nonprofit educational and research orga- nization established by APTA. TDC is responsible for forming the independent governing board, designated as the TCRP Oversight and Project Selection (TOPS) Committee. Research problem statements for TCRP are solicited periodically but may be submitted to TRB by anyone at any time. It is the responsibility of the TOPS Committee to formulate the research program by identi- fying the highest priority projects. As part of the evaluation, the TOPS Committee defines funding levels and expected products. Once selected, each project is assigned to an expert panel, appointed by the Transportation Research Board. The panels prepare project state- ments (requests for proposals), select contractors, and provide techni- cal guidance and counsel throughout the life of the project. The process for developing research problem statements and selecting research agencies has been used by TRB in managing cooperative research pro- grams since 1962. As in other TRB activ ities, TCRP project panels serve voluntarily without com pensation. Because research cannot have the desired impact if products fail to reach the intended audience, special emphasis is placed on dissemi- nating TCRP results to the intended end users of the research: tran- sit agencies, service providers, and suppliers. TRB provides a series of research reports, syntheses of transit practice, and other support- ing material developed by TCRP research. APTA will arrange for workshops, training aids, field visits, and other activities to ensure that results are implemented by urban and rural transit industry practitioners. The TCRP provides a forum where transit agencies can cooperatively address common operational problems. The TCRP results support and complement other ongoing transit research and training programs. Published reports of the TRANSIT COOPERATIVE RESEARCH PROGRAM are available from: Transportation Research Board Business Office 500 Fifth Street, NW Washington, DC 20001 and can be ordered through the Internet at http://www.national-academies.org/trb/bookstore Printed in the United States of America

The National Academy of Sciences is a private, nonprofit, self-perpetuating society of distinguished scholars engaged in scientific and engineering research, dedicated to the furtherance of science and technology and to their use for the general welfare. On the authority of the charter granted to it by the Congress in 1863, the Academy has a mandate that requires it to advise the federal government on scientific and technical matters. Dr. Ralph J. Cicerone is president of the National Academy of Sciences. The National Academy of Engineering was established in 1964, under the charter of the National Academy of Sciences, as a parallel organization of outstanding engineers. It is autonomous in its administration and in the selection of its members, sharing with the National Academy of Sciences the responsibility for advising the federal government. The National Academy of Engineering also sponsors engineering programs aimed at meeting national needs, encourages education and research, and recognizes the superior achievements of engineers. Dr. Charles M. Vest is president of the National Academy of Engineering. The Institute of Medicine was established in 1970 by the National Academy of Sciences to secure the services of eminent members of appropriate professions in the examination of policy matters pertaining to the health of the public. The Institute acts under the responsibility given to the National Academy of Sciences by its congressional charter to be an adviser to the federal government and, on its own initiative, to identify issues of medical care, research, and education. Dr. Harvey V. Fineberg is president of the Institute of Medicine. The National Research Council was organized by the National Academy of Sciences in 1916 to associate the broad community of science and technology with the Academy’s purposes of furthering knowledge and advising the federal government. Functioning in accordance with general policies determined by the Academy, the Council has become the principal operating agency of both the National Academy of Sciences and the National Academy of Engineering in providing services to the government, the public, and the scientific and engineering communities. The Council is administered jointly by both Academies and the Institute of Medicine. Dr. Ralph J. Cicerone and Dr. Charles M. Vest are chair and vice chair, respectively, of the National Research Council. The Transportation Research Board is one of six major divisions of the National Research Council. The mission of the Transporta- tion Research Board is to provide leadership in transportation innovation and progress through research and information exchange, conducted within a setting that is objective, interdisciplinary, and multimodal. The Board’s varied activities annually engage about 7,000 engineers, scientists, and other transportation researchers and practitioners from the public and private sectors and academia, all of whom contribute their expertise in the public interest. The program is supported by state transportation departments, federal agencies including the component administrations of the U.S. Department of Transportation, and other organizations and individu- als interested in the development of transportation. www.TRB.org www.national-academies.org

C O O P E R A T I V E R E S E A R C H P R O G R A M S CRP STAFF FOR TCRP REPORT 156 Christopher W. Jenks, Director, Cooperative Research Programs Crawford F. Jencks, Deputy Director, Cooperative Research Programs Lawrence D. Goldstein, Senior Program Officer Anthony Avery, Senior Program Assistant Eileen P. Delaney, Director of Publications TCRP PROJECT G-12 PANEL Field of Administration Gale Fisk, Greater Cleveland Regional Transit Authority (Chair) Craig R. Allen, Capital Area Transportation Authority, Lansing, MI Jon D. Fricker, Purdue University, West Lafayette, IN W. Peter Wallace, Charlotte Area Transit Systems, Charlotte, NC Elizabeth Way, Metro-North Railroad, New York, NY Lewis Carroll, FTA Liaison Martin Schroeder, APTA Liaison

TCRP Report 156 is a guidebook for public transit agency professionals on how to identify and evaluate risks and uncertainties with respect to fuel prices, and describes tools and techniques for minimizing the impact of these uncertainties over time. This guidebook introduces the concept of fuel price risk management to public transit agencies, identifying alternative purchasing strategies and outlining steps necessary to implement an effective risk management program. It defines and evaluates alternative cost-effective fuel purchasing strategies designed to benefit public transportation agencies of varying sizes, and it provides a management framework to assist transit agencies through the fuel purchasing process. While using this guidebook, it is important to recognize that “risk management” is distinct from “removal of risk.” It does not assure the lowest fuel prices; rather, it seeks to control the impact of price swings on overall transit system operating budgets. The cost of fuel for transit system operations has been increasing in real terms as well as in terms of percentage of total operating expenses. In addition, fuel costs have exhibited a continuing high level of volatility, undermining a transit agency’s ability to forecast future costs with any degree of certainty. What makes forecasting so difficult is that prices are influenced by many disparate factors, including world-wide supply and demand as well as international political uncertainties in oil producing regions throughout the world. Past significant fuel price increases have had a negative impact on transit system budgets, limiting resources available for expansion while making it difficult to maintain current operations. In addition, higher gasoline prices contribute to increased demand for and dependency on public transit services. Increased demand for transit service creates a greater need for transit agencies to at least maintain current service levels. Given that transit agen- cies often have a limited ability to raise revenues, volatile fuel prices can have a significant impact on both near- and long-term planning. An effective response requires innovative fuel acquisition strategies as part of an overall service delivery plan. These strategies can incorporate the use of future contracts, derivatives, swap strategies, spot market, joint pur- chasing, and other options. Long-term fuel acquisition strategies must also recognize that transit agencies differ in size and ability to access federal, state, and local funding sources. The guidebook focuses on developing an understanding of key concepts of fuel price risk management at public transit agencies, and it also summarizes the procedural steps for implementing a strategic plan. Two types of energy price risk are addressed: commodity price risk and delivery price risk with the greater emphasis placed on the discussion of commodity price risk, which is considered the greater of the two. As a major component of the research, the guidebook presents various options for helping consumers manage or “hedge” exposure to risk. F O R E W O R D By Lawrence D. Goldstein Staff Officer Transportation Research Board

Several important steps need to be implemented to benefit from hedging. Transit agen- cies need to solicit transit agency management interest and support, obtain stakeholder backing, and develop and implement hedging strategies that are most appropriate for a particular agency. None of these steps are necessarily simple or uniformly applicable, as conditions vary with agency, management structure, size and service characteristics, as well as other factors. As a result, effective tools and techniques will vary by transit agency, local government regulations and practices, and by state. Each individual agency must consider the framework and context for risk management decisions and implement strategic plans accordingly, using and building on the evaluations presented in this guidebook. This guidebook has been designed for the public transit agency professional; however, it may also be of interest to other groups responsible for large transportation system fuel pur- chases, including state, municipal, and private fleet operators. Considering the nature of the topic, financial institutions as well as private sector suppliers, particularly those interested in hedging in concert with the transit industry, are also potential audiences. To help formulate this guidebook, case studies of fuel purchasing strategies were carried out for 15 transit agencies across the U.S. and Canada. These case studies were based on direct interviews with transit agency representatives. Detailed summaries of these case studies are included as an appendix, providing examples of real-world experience. In addition, a wide range of transit agency representatives were invited to review and comment on the guidebook. Their comments have further enhanced the final product.

1 Section 1 Introduction 1 1.1 Why Manage Fuel Price Risk? 3 1.2 Types of Energy Price Risk 5 1.3 Classification of Fuel Purchasing Strategies 7 Section 2 The Basics of Commodity Price Risk Management 7 2.1 Goals of Hedging 7 2.2 Components of Hedging Strategy 8 2.3 Hedging Instruments 10 Section 3 Hedging with Forward-Price Instruments 11 3.1 Futures Contracts 18 3.2 Over-the-Counter Swap Contracts 20 3.3 Firm, Fixed-Price Supply Contracts 23 Section 4 Hedging with Cap-Price Instruments 23 4.1 Options Contracts 30 4.2 Web-Based Fuel Price Protection Programs 35 Section 5 Summary and Evaluation of Hedging Instruments 35 5.1 List of Hedging Instruments 36 5.2 Objective Criteria 37 5.3 Matrix of Hedging Instruments by Criteria 38 5.4 Appropriateness of Hedging Instruments 39 Section 6 Hedging Level, Duration, and Timing 39 6.1 Hedge Level 40 6.2 Hedge Duration 42 6.3 Hedge Timing 47 Section 7 Delivery Price Risk Management 47 7.1 Long-Term, Fixed-Margin Contracting 48 7.2 Competition Strategies 51 7.3 Market Power Strategies 52 7.4 Effectiveness of Delivery Price Risk Management Strategies 54 Section 8 Program Implementation 54 8.1 Evaluate Impact of Fuel Price Volatility on Budget Variance 54 8.2 Educate Staff About Hedging 55 8.3 Obtain Authorization to Hedge 56 8.4 Develop Hedging Policy 56 8.5 Identify Qualified Derivative Brokers or Counterparties 57 8.6 Negotiate Counterparty Agreements 58 8.7 Begin Hedging C O N T E N T S

59 Glossary 65 Acronyms and Abbreviations 66 Appendix A Case Studies Note: Many of the photographs, figures, and tables in this report have been converted from color to grayscale for printing. The electronic version of the report (posted on the Web at www.trb.org) retains the color versions.